There are various ways that individuals can get involved in real estate investing. One way to start is by investing in private equity funds or real estate trusts, also known as REITs. Both of these approaches are appealing because they are accessible for anyone who lacks resources that can be hard to obtain such as capital, deal flow, and expertise. They are also promising avenues for anyone hoping to find a passive investment strategy that demands no management responsibility. Private equity funds and REITs each provide their own set of risks and benefits to an individual investor, and before delving into either, it is imperative to understand the difference.
Real Estate Private Equity Fund
A real estate equity fund is essentially a partnership established to raise equity for ongoing real estate investment. Investing in this asset class involves the acquisition, financing, and ownership of a property or multiple properties via a pooled vehicle. The typical structure involves one person who is in charge, often called the general partner or sponsor. The general partner creates a fund and identifies others who might invest in the project. These additional investors are known as limited partners. Once enough capital is raised, the partnership invests in real estate development or acquisition opportunities, and the property and it’s portfolio is managed by the general partner.
Getting started with a fund can be a bit challenging since often it requires much more capital upfront. Additionally, when considering this route, investors need to be prepared for the long haul since funds often require a long holding period and are not liquid (you cannot simply cash out when you need to). These investments also tend to pose more risk because the success of the return depends on the experience, expertise, and track record of the investors.
Before committing to one fund, investors need to fully understand the structure of the fund. Since these funds are not always regulated, they can differ depending on the opportunity – variations may exist in fee structures and compensation, partnership organization, and the exit strategy. However, a smart investment can prove beneficial and result in a return upward of 8%. Additionally, investors can benefit from the tax benefits of investing in a real estate equity fund – These funds are structured in a tax-efficient manner which allows participating investors to reduce taxable income through the use of depreciation. That number could be huge depending on how a fund manages the deal.
Real Estate Investment Trust
On the other hand, REITs are more similar to an equity mutual fund. A REIT invests in and manages a portfolio of real estate — generally, properties that are in the same asset class. Investors can buy into the portfolio of their liking and reap the benefits of real estate investing.
REITs, unlike private equity funds, are regulated, and therefore they must meet specific criteria outlined by the IRS. They must invest at least 75% of their total assets in real estate; derive at least 75% of gross income from rents on real property, interest on mortgages financing real property or from sales of real estate; pay at least 90% of taxable income in the form of shareholder dividends annually; be an entity that is taxable as a corporation; be managed by a board of directors or trustees; have a minimum of 100 shareholders; and place no more than 50% of their shares in the hands of fewer than six individuals. Requiring REITs to follow the regulations outlined above can provide investors transparency in their investment. (*Note: There are, however, two different kinds of REITs that investors should be aware of – traded and untraded REITs. Publicly traded REITS can be traded on the stock market and are regulated by the SEC while untraded are private and do not follow the same regulations.)
The benefits and disadvantages of investing in REITs differ from those of investing in a real estate private equity fund. The benefits are directly related to flexibility and security – The properties are managed by professionals, and the historical performance of the REIT is available to any investor; the fees are straightforward, and trading operates similarly to the trading of stocks (investors pay broker fees for the transactions); investors pay no corporate tax, and they are often receive high dividends; and the investment is liquid, meaning investors can sell their shares at any time.
All of that sounds great! There are, of course, downsides to investing in REITs as well. The first is the taxes that investors pay on dividends; the dividends are generally taxed at a higher rate than ordinary income is taxed. Second, in non-traded REITs, the associated fees can be much higher. Lastly, individuals investing in REITs pay a liquidity premium. Because REITs are one of the few ways people can invest in real estate while maintaining liquid capital, there is a premium that investor must pay that they would otherwise not pay if they were simply investing in real estate themselves. This means that the return for the REIT may yield less than the same deal invested from a fund.
Which to Invest In?
As you can see, there are many pros and cons to each strategy, and the approach that best suits an individual investor will depend on the individual’s resources, their comfort with risk, and their goals. An investor looking for a more liquid, stable, and diversified option might find that a REIT could be the best fit. However, for those really looking to get involved in the market and benefit from longer term projects, investing in private equity is worth considering.
Read If You Should Be Investing in Private Equity Funds, REIT’s Or Other Syndications.
